How mutual fund fees can cost you big bucks

Robert Farrington from The College Investor recently went to bat for one of his readers. “I feel like my advisor isn’t steering me in the right path,” his reader told him. “When I mention [index funds] to him, he changes the subject or diverts to other topics.”

Farrington ran the numbers and discovered that his reader’s financial advisor stood to gain $7247.50 in commissions by recommending expensive mutual funds. But that’s not all. “When you add in the expense ratio, this portfolio is costing the investor $11,004.71 in year one,” Farrington writes. “And potentially costing the investor $1,879.21 or more per year after!” (And that doesn’t include any commissions and fees created by rebalancing the portfolio periodically.)

As an experiment, Farrington looked at what it would take to move his reader’s existing portfolio to low-cost index funds. The results were shocking: “By simply investing in a low cost portfolio, we were able to reduce total costs from $11,004.71 to just $176.60. That’s a 99% reduction in costs.”

This reminds me of a story from my own life.

Boxed In by Bad Investments

Before my father died in 1995, he set up a profit-sharing plan for the employees of the family box factory. Each year, the company contributed some amount (up to 15% of all employees’ earnings per year) into an investment account. Because we didn’t know any better, we used a big-name brokerage firm to manage this money.

My cousin Nick, who is a bit of a money nerd, kept records for the box company. After a few years, he noticed something strange. Although the stock market was booming because of the tech bubble, our investment accounts were not. In fact, they were barely growing at all. He did some digging and his research left him fuming. We had trusted that the big-name brokerage firm was doing their best for us, but that wasn’t the case. They were doing their best for themselves.

When I asked Nick if he remembered this (after almost twenty years), he certainly did. “It pissed me off,” he said. The brokerage had us invested in what was called a Unit Investment Trust. Here’s how Nick describes the situation:

The Unit Investment Trust consisted of a bundle of stocks selected to be purchased by [the brokerage firm] to meet some investment criteria. Units of this bundle could be purchased for $1.00 plus an 8% commission.

At a specific time they purchased the stock and held it for one year. At the end of the year they sold the stock and took their 4% management fee and distributed the rest of the funds to those that had purchased units. Then do it all over again. I don’t recall the actual commission and fee rates but it seems that the total was about 12%.

Can you believe it? The big-name brokerage was screwing us over to the tune of nearly twelve percent per year. It’s this kind of bullshit that makes me such a vocal advocate of do-it-yourself investing with index funds. I don’t care what kind of returns your broker promises you. They’re not going to be enough to compensate for fees of 12%! (And yes, I know, there are ethical advisors out there. But how can you tell the good from the bad?)

This is also an example of why one of the core tenets of Get Rich Slowly is nobody cares more about your money than you do. It’s very easy to trust professionals — whether they’re brokers or realtors or, well, bloggers — just because they have perceived position of authority. The advice that others give you is almost always in their best interest, which may or may not be the same as your best interest. Do your own research, get advice from a variety of sources, and in the end, make your own decisions based on your own goals and values.

Den of Thieves

The sad part of this is that it takes a lot of time and effort to figure out what you’re actually paying your financial advisor. I spent about an hour researching the fees, expense ratios, and commissions that the financial advisor was receiving for this article. And most people won’t be spending their time doing that.

I believe it should be illegal for any broker, financial advisor, fiduciary, brokerage firm, salesperson, or anyone else having contact with a client’s money to receive any compensation or distribute any payment related to that account that isn’t clearly disclosed upfront and direct in the form of a financial statement.

Written disclosures in contracts aren’t adequate because few people read or understand them, and not having any disclosure is completely unacceptable. You must show the client the money – that’s the key point.

If you really want to be grossed out by the pirates of Wall Street, read Den of Thieves, the 1992 bestseller from James B. Stewart. This book recounts the insider trading scandals of the 1980s, when names like Ivan Boesky and Michael Milken were prominent in the news.

Den of Thieves didn’t just open my eyes to the actions of these well-known crooks; it exposed just how much money the big-name brokerages as a whole bleed from our economy. And they do it by taking advantage of everyday people like you and me.